A Critical Note on MCEV Calculations Used in the Life Insurance Industry

Transcription

1 A Crtcal Note on MCEV Calculatons Used n the Lfe Insurance Industry Faban Suarez 1 and Steven Vanduffel 2 Abstract. Snce the begnnng of the development of the socalled embedded value methodology, actuares have been usng the present value of future profts as yardstck when valung lfe nsurance actvtes. However, usng profts as a fundamental nput s subject to crtcsm because profts are no actual cash flows. In an attempt to create more transparency and robustness the CFO forum (2008) has set a defnton for market consstent embedded value (MCEV). Nevertheless, ths defnton refers agan to the present value of future profts. In ths note we show that such a defnton s msleadng and, nstead of creatng more transparency, t could end up n creatng more confuson. 12 Keywords: Embedded value, MCEV, far value, cash flow projectons, busness valuaton, profts, cash flows. 1 The Hstory of Embedded Value 1.1 The Orgns The embedded value methodology was devsed and developed n the nneteen eghtes, manly n Anglo-Saxon countres. The reason for such development was the ncreasng demand from shareholders and nvestors for more accurate and relable nformaton about the value generated by lfe nsurance companes. Shareholder value became a key concept and nsurance companes started mplementng nternal processes to montor the value created by ther busness actvtes. Due to the nherent characterstcs of the lfe nsurance contracts,.e. the dstrbuton of expendture and ncome over a long perod of tme resultng from the usually long contract terms, there was a growng feelng that the tradtonal hstorcally-orented accountng nformaton was nadequate to measure the ntrnsc value generated by lfe nsurance actvtes. Indeed the tradtonal accountng was not forward lookng and dd not allow answerng key questons such as: How much value s locked up n the company? How senstve s the value to changes n key assumptons? All ths gave a sgnfcant mpulse for the development of the embedded value concept. Whle embedded value was orgnally used to determne a company's shareholder value 1 faban.suarez@actuarsk.be, ActuaRsk, Rue Sant Norbert 53, 1090 Brussels 2 steven.vanduffel@vub.be, Vrje Unverstet Brussel, Plenlaan 2, 1000 Brussels or the prce n case of an acquston or merger, t has been used gradually by nsurance companes for the nternal control and adjustment of ther strategy. 1.2 The CFO Forum The CFO Forum was created n 2002 and s a hgh-level dscusson group composed by the Chef Fnancal Offcers of major European nsurance companes 3. Its am s to dscuss ssues that are related to fnancal reportng developments for ther busnesses, and to create greater transparency for nvestors. In partcular, n May 2004, the CFO Forum launched European Embedded Value (EEV) Prncples, together wth addtonal gudance on dsclosures n October 2005, to address the treatment of guarantees and optons and provded the nsurance ndustry wth mproved senstvtes and dsclosures wthn ther fnancal statements. In June 2008, the CFO Forum publshed a new set of socalled Market Consstent Embedded Value Prncples (MCEV), whch should brng addtonal consstency and mprove dsclosure. The adopton of the MCEV Prncples should delver: A shareholder s perspectve on value, beng the present value of future cash flows avalable to the shareholder, adjusted for the rsks of those cash flows; A market consstent approach to fnancal rsk; A greater focus on dsclosng cash emergng from covered busness; Dsclosure of combned Group MCEV nformaton. The MCEV Prncples wll replace the EEV ones and wll be mandatory for CFO Forum members as of year ended 31 December 2009 wth early adopton possble. 1.3 The MCEV Defnton of the CFO Forum Accordng to the CFO Forum (2008) MCEV represents the present value of shareholders nterests n the earnngs dstrbutable from assets allocated to the covered busness after suffcent allowance for the aggregate rsks n the covered busness has been made. The allowance for rsk should be calbrated to match the market prce for rsk 3 Aegon, Allanz, Avva plc., AXA, BNP Parbas, CNP, Forts, General, Hannover Re, IF P&C, ING, Legal & General, Mapfre, Munch Re, Old Mutual, Prudental, Scottsh Wdows, Standard Lfe, Swss Re, Zurch FS BELGIAN ACTUARIAL BULLETIN, Vol. 8, No. 1, 2008

2 where relably observable. The MCEV conssts of the followng components: free surplus allocated to the covered busness; requred captal; and value of n-force covered busness (VIF). The CFO Forum contnues by provdng the followng clarfcatons for the dfferent components nvolved. Free Surplus The free surplus s the market value of any assets allocated to, but not requred to support, the n-force covered busness at the valuaton date. Requred Captal Requred captal s the market value of assets, attrbuted to the covered busness over and above that requred to back labltes for covered busness, whose dstrbuton to shareholders s restrcted. Value of In-Force Covered Busness The value of n-force covered busness conssts of the followng components: present value of expected future profts (where profts are post taxaton shareholder cash flows from the nforce covered busness and the assets backng the assocated labltes) (PVFP); tme value of fnancal optons and guarantees; frctonal costs of requred captal; cost of resdual non hedgeable rsks. The purpose of ths document s not to detal the dfferent elements of the MCEV calculaton, but rather to demonstrate that the defnton provded s msleadng. Indeed, ths defnton refers to dfferent concepts such as shareholders nterests n the earnngs dstrbutable, profts or cash flows, but not all these concepts can be used for valuaton purposes. Whle earnngs and profts are smlar concepts cash flows are of a dfferent nature. The next secton wll frst gve a hgh-level overvew of the major fnancal statements and wll detal the relaton and the dfferences between profts and cash flows. 2 Overvew of Fnancal Statements Accountng organses and summarses economc nformaton so decson makers can use t. Accountants present the nformaton n reports called fnancal statements. To prepare these statements, accountants analyse, record, quantfy, accumulate, summarse, classfy, report, and nterpret economc events and ther fnancal effects on the organsaton. Accountng helps decson makng by showng where and when a company spends money and makes commtments, provdng nformaton for evaluatng fnancal performance, and llustratng the fnancal mplcatons of choosng one plan nstead of another. Accountng also helps to predct the future effects of decsons, and fnally t adds to dentfyng current weaknesses, mperfectons and neffcences as well as opportuntes. Lsted companes prepare the followng fnancal statements on a quarterly bass: the balance sheet whch provdes a fnancal pcture at a set date; the ncome statement and cash flow statement whch focus on the performance over tme. In ths secton, we detal the nformaton provded by these fnancal statements and show how we have to lase t wth valuaton models. 2.1 The Balance Sheet One of the major fnancal statements prepared by the accountng system s the balance sheet. The balance sheet shows the fnancal status of a company at a partcular nstant n tme. It s essentally a snapshot of the organsaton at a gven date. It has two counterbalancng sectons. The left sde lsts assets,.e. resources of the frm (everythng the frm owns and controls from cash to buldngs, etc). The rght sde lsts labltes,.e. the clams aganst the resources. Every transacton entered nto by a company affects the balance sheet. A transacton s any event that affects the fnancal poston of an entty and that an accountant can relably record n money terms. When accountants record a transacton, they make at least two entres so the total assets always equal the total labltes plus shareholders' equty. Therefore, we must mantan the equalty of the balance sheet equaton for every transacton. An accountant who prepares a balance sheet that does not balance has made a mstake somewhere because the balance sheet must always balance. Cash Inventores Accounts recevable Long term assets Proprety Plants / Equpment Balance Sheet Overvew Current assets Fxed assets Workng Captal Current labltes Long-term debt Shareholders equty Short-term debt Accounts payable Workng captal (also known as net workng captal) s a fnancal metrc whch represents the amount of day-by-day operatng lqudty avalable to a busness. Along wth fxed assets such as plant and equpment, workng captal s 55

3 consdered a part of operatng captal. It s calculated as current assets mnus current labltes. 2.2 The Income Statement Measurng ncome s mportant to everyone, from ndvduals to busnesses, because we all need to know how well we are dong economcally. Most people regard ncome as a measure of the ncrease n the wealth of an entty over a perod of tme. However, there s less agreement on just what wealth s and how we should measure t. Nevertheless, accountants have agreed on a common set of rules for measurng ncome and wealth that all companes are supposed to apply (GAAP 4 IFRS 5 ). Decson makers such as nvestors can more easly compare the performance of one company wth that of another when both companes use the same measurng rules. The calendar year s the most popular tme perod for measurng ncome or profts. However, companes can use a fscal year that dffers from a calendar year. Revenues and expenses are the key components n measurng ncome. These terms apply to the nflows and outflows of assets that occur durng a busness's operatng cycle. Companes gan assets when they sell products or servces and record sales revenues whch ncrease the owner's nterest (equty) n the busness by the amount of assets receved n exchange for the delvery of goods or servces to customers. In contrast, companes gve up assets when they recognse expenses, whch decrease the owner's nterest. Expenses are measures of the assets that a company gves up or consumes n order to delver goods or servces to a customer. Together revenues and expenses defne the fundamental meanng of ncome, whch, s smply the excess of revenues over expenses. Common synonyms for ncome are profts or earnngs. One of the fundamental features of corporate fnancal reports s that they are prepared usng accrual rather than cash accountng. Unlke cash accountng, accrual accountng dstngushes between the recordng of costs and benefts assocated wth economc actvtes and the actual payment and recept of cash. Another mportant concept n accountng s the matchng prncple whch lnks revenues to the expenses that pertan to the revenues. When expenses are matched wth revenues, they are not recognsed untl the assocated revenue s also recognsed. For nstance, the cost of purchasng a fxed asset s spread over the perod n whch t s expected to generate revenue. Net proft s the prmary perodc performance ndex under accrual accountng. To compute net proft, the effects of economc transactons are recorded on the bass of expected, not necessarly actual, cash recepts and payments. Expected 4 Generally Accepted Accountng Prncples 5 Internatonal Fnancal Reportng Standards cash recepts from the delvery of products or servces are recognsed as revenues, and expected cash outflows assocated wth these revenues are recognsed as expenses. In other words, the ncome statement ncludes what we call non-cash transactons such as amortsaton of ntangble assets, deprecaton of tangble assets or the ncrease/decrease n polcyholder reserves to quote the most popular ones. Therefore, f we defne a cash flow as the term that refers to the amount of cash beng receved and spent by a busness durng a defned perod of tme, yearly profts are not cash flows. Nevertheless, the ncome statement s an mportant lnk between two balance sheets: ncome statements are fllng n the gaps between balance sheets. The balance sheets show the fnancal poston of the company at dscrete ponts n tme, and the ncome statements explan the changes that have taken place between those ponts. More specfcally, ncome statements explan the change n one balance sheet tem: retaned earnngs (total cumulatve shareholders equty generated by profts). 2.3 The Statement of Cash Flows The prmary mportance of cash makes the statement of cash flows one of the central fnancal statements. It explans the changes that occur n the frm's cash balance durng the year. The statement of cash flows allows both nvestors and managers to keep ther fngers on the pulse of any company's lfeblood cash. Although managers and nvestors beneft from watchng cash flows, untl recently many countres dd not requre a statement of cash flows. Today, both the IASB 6 and FASB 7 requre a statement of cash flows. Balance sheets show the status of a company at a sngle pont n tme. In contrast, statements of cash flows and ncome statements show the performance of a company over a perod of tme. Both explan why the balance sheet tems have changed. The statement of cash flows explans where cash came from durng a perod and where t went. Balance sheet December 31 20X0 Income statement Explans the change n retaned earnngs Cash flow statement Explans the change n the cash account 6 Internatonal Accountng Standards Board 7 Fnancal Accountng Standards Board Balance sheet December 31 20X1 56

4 Managers affect cash by three types of decsons: operatng, nvestng, and fnancng decsons. Operatng actvtes are transactons that affect the purchase, processng, and sellng of a company's products and servces. Ths nformaton are summarsed n the secton of the statement of cash flows labelled cash flows from operatng actvtes. For nstance, projectng the balance sheet over tme allows the assessment of the evoluton of the solvablty over tme from whch we can derve economc captal (ECAP) measures. Forecastng future ncome statements provdes useful nformaton on the proftablty of frms. Fnally, projectng cash flows s the key element for valuaton purposes. The graph hereunder gves an overvew of these dfferent aspects: The statement of cash flows covers the results of nvestng decsons n a secton labelled cash flows from nvestng actvtes. Investng actvtes are transactons that acqure or dspose of long-lved assets assets that the company expects to provde servces for more than a year. The secton of the statement of cash flows labelled cash flows from fnancng actvtes wll help us to understand fnancng decsons. Fnancng actvtes are a company's transactons that obtan resources as a borrower or ssuer of securtes or repay credtors and owners. Solvency related measures, e.g.: ECAP Fnancal statements Balance sheet Cash flow statement Valuaton models Income statement Proft testng The statement of cash flows can be summarsed as follows: Cash Inflows Operatng actvtes Collectons from customers Interest and dvdends collected Investng actvtes Sale of property, plant and equpment Sale of securtes that are not cash equvalent Recept of loan repayments Fnancng actvtes Borrowng cash from credtors Issung equty securtes Issung debt securtes Cash Outflows Cash payments to suppler Cash payments to employees Interest and taxes pad Purchase of property, plant and equpment Purchase of securtes that are not cash equvalent Makng loans Repayment of amounts borrowed Repurchase of equty shares Payment of dvdends The dfference between cash flows from operatng and nvestng actvtes defnes an mportant concept used for valuaton purposes: free cash flow (FCF). Free cash flow s the amount of cash that a frm can pay out to nvestors after payng for all nvestments necessary for growth. The value of a busness s usually computed as the dscounted value of free cash flows out to a valuaton horzon (T), plus the forecasted value of the busness at the horzon, also dscounted back to present value. In the context the nsurance ndustry, the valuaton horzon s generally the perod to whch all contacts wll mature. 2.4 Extendng the Use of Fnancal Statements Fnancal statements provde the most wdely avalable data on publc corporaton s economc actvtes. The projectons of these reports over tme provde useful nformaton for the decson makers of frms. 3 Valuaton Models The economc value of the frm s ntmately connected to the projected future cash flows. To show why ths s actually true let us take a step back and draw a parallel wth the prcng of fxed ncome securtes n fnancal markets. Assume a smple rsk free fxed ncome nstrument whch offers a cash flow of 1,05 to the buyer of the contract after a perod of one year and let us assume that the rsk free rate s 5%. One wll realse that the value of ths cash flow must be 1 otherwse arbtrage opportuntes exst. For example, f the value s lower than 1 (say 0,95) then the buyer could smply borrow 0,95 to fnance ts nvestment, next rembursng 0, Euros after one year and by recevng 1,05 makng a proft out of nothng (the case that the value s hgher than 1 can be smlarly treated). Often cash flows are not fxed but stochastc and ths makes the valuaton more complcated. However when these cash flows can be effectvely assocated to market nstruments then the absence of arbtrage opportuntes s agan determnng the prcng unquely. In fact the market nstruments can then be used to construct so-called replcatng portfolos whch allow to mmc the cash flow under consderaton and n the absence of arbtrage opportuntes the value of the cash flow stream must then be equal to the objectve value of such replcatng portfolo. In all these nstances the prcng effectvely amounts to calculatng the expected cash flows usng so-called rsk neutral probabltes, next dscountng these expected cash flows at the rsk free rate. On the other hand, when cash flows are stochastc but cannot be replcated usng market nstruments (e.g. non-lfe nsurance labltes) then the prcng becomes more subjectve. 57

5 However as shown n Secton 2, profts are not cash flows and, therefore, what actuares tradtonally called PVFP (.e. present value of future profts) can n any case not be used to derve the value of lfe nsurance portfolos. Indeed, profts are dependent on accountng rules whle the valuaton of a company s ndependent of these rules as t depends only on the cash ths company s able to generate. Hence for valuaton purposes, we have to determne frst the amount of cash that s left over for shareholders over tme. Assumng that the company does not use external fnancng and does not accumulate cash, the amount of cash left over to shareholders s the free cash flow. Moreover, the consequence of ths assumpton s that valuaton models have to focus only on nvestng and operatng flows. To get the free cash flow from net ncome, some adjustments are requred. Hereunder, we detal the adjustments needed: Revenues Expenses (Operatng) Proft Taxes Net Income (NI) 1. Adjustments to reconcle NI to cash provded by operatng actvtes: + Deprecaton of tangble assets (D) + Amortsaton of ntangble assets (A) + Polcyholder reserves (PR) + Provsons (P) Net workng captal (NWC) Losses/gans on sales of long-lved assets (LG) Cash provded by operatons (OCF) = NI + D + A + PR + P NWC LG 2. Adjustments due to nvestng transactons: + Purchase fxed assets for cash (PFA) Sell fxed assets for cash (SFA) + Purchase nvestment securtes of other frms that are not cash equvalent (PIS) Sell nvestment securtes of other frms that are not cash equvalent (SIS) + Make a loan to another company or person (ML) Collect a loan (CL) Cash provded by nvestments (ICF) = PFA - SFA + PIS - SIS + ML - CL The free cash flow s then defned as follows: Free cash flow (FCF) = OCF ICF Based on ths, the value of the busness FV bus s determned by the followng equaton: FV T bus = =1 FCF df + PV df, where FCF s the expected free cash flow generated on year, df s the dscount factor of year, T s the valuaton horzon and PV T s the forecasted value of the busness at T. When cash flows are stochastc and not replcable, ther expectatons are taken wth respect to real-world subjectve probabltes. The dscount factor s then subjectve as well and could be derved, for nstance, from the weghted average cost of captal (WACC). In contrast when cash flows are replcable (also called hedgeable) a rsk free rate should be used for dscountng as well as rsk neutral probabltes for calculatng the expectatons. 4 Determnng the VIF: an Example In ths secton, we present a smple example to show the relatons between the balance sheet, the ncome statement and the statement of cash flows. We detal also where the nformaton to value busness actvtes can be found. Let us assume that we have to determne the value of the nforce busness of an nsurance company havng a bond portfolo wth a book value of 100 (the bonds were ssued at par and earn a coupon of 3%) and owng polcyholder reserves of 100. The value of the dffered acquston costs (DAC) assocated to these labltes are worth 10. Therefore at tme 0, the balance sheet of ths company s as follows: Assets DAC 10 Bonds 100 Total 110 Labltes Polcyholder Reserves 100 Retaned Earnngs 10 Total 110 For the sake of smplcty, we make the followng assumptons: The remanng term of all nsurance contracts s 5 years They all guarantee a death captal of 600 The 1 year mortalty rate s 3% for all ages (.e. 1 q x+t = 3%, t) The nterest guaranty on premum and reserves s 2,5% The total wrtten premum are equal to 20 and are due at the begnnng of the year After 5 years, reserves are pad back to polcyholders No proft sharng s dstrbuted. Admnstratve expenses are calculated as a percentage of the premum and are equal to 15% Expenses are pad at the end of the year DAC s amortsed 20% per year. T T 58

6 New assets (bonds and cash) earn the rsk-free rate 95% of the ncrease of reserves are nvested, at the begnnng of each year, n new bonds whch are ssued at par wth a maturty equal to the remanng term of nsurance contracts. The rsk-free rate s flat durng 5 years and s equal to 5% The tax rate s equal to 0% Nobody wll de durng the next 5 years. The valuaton horzon we consder s 5 years. In our example, we can neglect tme value of fnancal optons and guarantees, frctonal costs of requred captal and cost of resdual non hedgeable rsks. We use tradtonal actuaral formulas to calculate future outcomes. The tables below present the evoluton of the three fnancal statements: Balance Sheet Year Assets DAC 8,00 6,00 4,00 2,00 0,00 Bonds 107,62 115,66 124,17 133,15 0,00 Total 115,62 121,66 128,17 135,15 0,00 Labltes Polcyholder reserves Retaned Earnngs 108,02 116,49 125,44 134,90 0,00 7,60 5,18 2,73 0,26 0,00 Total 115,62 121,66 128,17 135,15 0,00 Income Statement Year Revenues Premum Investment Income 4,00 4,38 4,78 5,21 5,66 Expenses Reserves -8,02-8,47-8,95-9,46 134,90 DAC amortsaton -2,00-2,00-2,00-2,00-2,00 Benefts 0,00 0,00 0,00 0,00-144,90 Admn Expenses -3,00-3,00-3,00-3,00-3,00 Proft 10,98 10,91 10,83 10,75 10,66 Taxes Net Income 10,98 10,91 10,83 10,75 10,66 Statement of Cash Flows Year Cash flow from operatng actvtes Net Income 10,98 10,91 10,83 10,75 10,66 Reserves 8,02 8,47 8,95 9,46-134,90 DAC amortsaton 2,00 2,00 2,00 2,00 2,00 OCF 21,00 21,38 21,78 22,21-122,24 Cash flow from nvestng actvtes Bonds Purchase 7,62 8,05 8,50 8,99 9,50 Matured Bonds 0,00 0,00 0,00 0,00-142,65 ICF 7,62 8,05 8,50 8,99-133,15 Free Cash Flow 13,38 13,33 13,28 13,22 10,92 Ths example shows that net ncomes and free cash flows explan the evoluton of the retaned earnngs. More precsely, retaned earnngs of year (RE ) can be obtaned as follows: RE = RE 1 + NI FCF, where NI and FCF are the net ncome and the free cash flow of year respectvely. Free cash flow has to be deducted n ths formula as t s consdered as the amount whch s dstrbuted to shareholders and pad back to them as dvdend. By dscountng net profts and free cash flows wth the rsk-free curve we get 46,91 and 55,74 respectvely. As for valuaton purposes the only thng whch matters s the cash left over to shareholders, the value of the n-force busness s 55,74.e. the present value of future cash flows. 5 Concluson In ths document, we have presented a valuaton approach whch s consstent wth modern fnancal modellng. Based on the projecton of the standard fnancal statements, we make the lnk between post tax profts and cash flows. As the objectve of the CFO forum was to create greater transparency for nvestors, we do not thnk that ths can be acheved f well-known concepts such as profts are redefned n the context of MCEV. Therefore, the CFO forum should avod defnng profts as post taxaton shareholder cash flows because, by dong ths, confuson s created. There s no reason why the defnton of wellknown concepts used n fnance and accountng should be changed n an nsurance context. Accordng to us, all reference to earnngs and profts should be removed from the defnton of the MCEV and should be replaced by cash flows. As a consequence, the PVFP concept, even f t s used snce the creaton of embedded value, should not be used anymore. We suggest to replace t by PVFCF,.e. the present value of future free cash flows. REFERENCES [1] CFO Forum (2008): Market Consstent Embedded Value Prncples, [2] Horngren, Sunden, Ellott, Phlbrck (2006): Introducton to Fnancal Accountng, PEARSON [3] Palepu K.G., Healy P. M., Bernard V. L. and Peek E. (2007): Busness Analyss and Valuaton IFRS edton, THOMSON 59